Category Archives: Eurozone

2020

It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021 will be considerably more joyful than 2020.

2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.

At the time of writing, app. 75 million cases of corona/COVID-19/SARS-CoV-2 have been confirmed globally and app. 1.7 million people have passed away because of corona. Most countries have been in lockdowns, many still are (again), and the social and economic costs of the crisis have been enormous.

I started this blog in April 2020. This had nothing to do with corona. I had wanted to set up a blog for some years (people ask me where I find time for this, and I really do not know, but seemingly I simply like writing economic stories and analyses). Starting the blog in April this year, however, naturally implied that many of the blog posts have dealt with various economic and financial aspects of the pandemic. In this post, I will review some of the learnings from 2020.

The worst recession on record. With the highest growth rate on record

The recession started in February 2020 in, e.g., the US. Initially, it was caused by a supply shock: lockdowns were imposed and firms could not sell their goods and services and households could not go shopping. In April, when the IMF released their Spring Outlook, they labelled it “The Great Lockdown”. This was a suitable label. The IMF also noted that “This is a crisis like no other” and that “many countries now face multiple crises—a health crisis, a financial crisis, and a collapse in commodity prices, which interact in complex ways”. As unemployment and bankruptcies increased, households and firm got nervous, and demand suffered, too.

The path of economic activity has been highly unusual. This graph shows the quarterly percentage changes in US real GDP since 1947:

Quarterly percentage changes in US real Gross Domestic Product. 2020 encircled.
Source: Fed St. Louis Database

2020 is very much an outlier. On average, from 1947 through 2020, real GDP has grown by 0.8% per quarter. Until 2020, quarterly growth had never exceeded 4%. Economic activity had never contracted by more than 2.6%. Then came the Great Lockdown. During the second quarter of this year, economic activity contracted by 9%. This is almost four times more than the otherwise worst contraction on record. In this sense, it was the worst recession ever.

It has also been the weirdest recession ever. During this recession, we have also witnessed the highest growth rate on record: economic activity expanded by 7.4% during Q3. This is twice as much as the otherwise highest growth rate on record.

This puzzling feature of the recession led me wondering what a recession really is (link). I expressed sympathy with members of the NBER Recession Dating Committee. They face a particularly difficult task this year. Should they conclude that we had one V in spring, with the recession ending in late April, and then a new V now, i.e. two separate Vs (VV), or that we have had one long recession with a double dip, i.e. a double-V (W)? Does it make sense to call it a recession when we experienced the fastest rate of growth in economic activity on record? If you conclude that the economy cannot be in recession when it expands at its fastest growth rate ever, then you must conclude that the recession ended during Q2. But, the NBER Recession Dating Committee has not called the end of the recession yet, i.e., officially, the recession is still ongoing.

You may ask why it is important to know whether the recession ended in April or whether it is still ongoing. The development in economic activity is what it is, whether we call it recession or not. It is important because a “recession” is such an important concept in economics. We inform the public, business leaders, students, and others about the characteristics and consequences of recessions. If a recession can contain the by-far strongest expansion of economic activity on record, we need to change our understanding of recessions.

The very unusual behavior of economic activity during Q2 and Q3 caused very unusual, and scary, developments in unemployment and related aspects of economic activity. This graph shows the monthly change in the number of unemployed in the US:

Monthly changes in the number of unemployed in the US. Millions. 2020 encircled.
Source: Fed St. Louis Database

During March, unemployment in the US increased by 16 million. Again, this was beyond comparison. Until March 2020, the number of unemployed had never increased by more than one million over one month. In March 2020, it increased by 16 million.

As the virus contracted during summer, unemployment fell. There has never been as fast a reduction in the number of unemployed as the one occurring during this summer. In May, the number of unemployed dropped by more than three million. Until May 2020, the number of unemployed had never fallen by more than one million over one month. In May 2020, it fell by more than 3 million. So, within a year, we have had the strongest-ever increase in unemployment, but also the largest-ever fall in unemployment. By far.

Such dramatic events happened all around the world. I documented this here (link) and here (link).

Inspired by these events, I did something admittedly nerdy. I calculated the probability that we would experience events such as these, given the historical data (link). I found the unconditional likelihood that we could see the increase in newly registered unemployed that we saw in spring to be 0.97 x 10^(-841). This is a zero followed by 841 zeroes and then 97. For all practical purposes, this is a zero-probability event. But it did happen. It was just very, very unusual.

The stock market

I use some of my time (a significant part, by the way) to try to understand the stock market. This has not been a straightforward task this year.

Today, the global stock market is 13% percent above its January 1 value, the US stock market is 18% higher, and the Danish stock market 29% higher (MSCI country indices). Given that we have been through the worst recession ever, and that the recession is not officially over yet, this is not what one would have expected prior to the events.

Then, on the other hand, in hindsight it is perhaps not so strange. The recession has been the worst on record, yes. But, we have also had the fastest growth in economic activity on record. I argued (link) that if we imagine that the recession ended in late April, when economic activity bottomed out, the behavior of the stock market fits perfectly well with the historical evidence on the behavior of the stock market.

Central banks have certainly played their role, too. When markets melted down in March, central banks intervened heavily. In contrast to the financial crisis of 2008, it was not banks that were in trouble this time, but firms. Firms could not sell their goods and services due to the lockdown. The limitless purchases of government bonds that central banks have become used to during and after crises thus probably did not do much good (evidence came out that central bank purchases of government bonds are less effective than we are often told, link ). What turned things around, instead, was the announcement on March 23 that the Fed would facilitate credit to firms (link). This was a new policy tool. It led to a complete turnaround of events. I produced this graph (I still think it is a supercool graph): 

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries (Left hand axis) as well as the SP500 inverted (Right hand axis). Both series normalized to one on January 2, 2020. Vertical line indicates March 23.
Source: Fed St. Louis Database

The graph shows how the stock market lined up with credit spreads. Firms were suffering, and their credit spreads started widening, in late February. The stock market suffered. The Fed announced it would provide credit to firms on March 23. Credit spreads tightened. The stock market cheered. The graph summarizes how the Fed saved credit and equity markets. And, strikingly, the Fed did so by merely announcing they would intervene. Up until today, the Fed has not intervened a lot. In this sense, it was a “Whatever it takes moment of the Fed”.

It should be mentioned that the Fed announced other initiatives on March 23, too, such as the Main Street Lending Program (link) and the Term Asset-Backed Securities Loan Facility (link). The Corporate Credit Facilities were the ones that directly targeted corporate bonds, though. Due to the nature of this crisis, the stock market lined up with credit spreads during this crisis, as the above graph reveals, emphasizing the importance of the announcement of the Corporate Credit Facilities.

Eurozone troubles, or rather no Eurozone troubles

The fact that we have not had to talk a lot about the risk of a Eurozone breakup since summer has been a positive surprise. In spring, there was talk about the risk of a Eurozone crisis. Like so often before, Italian sovereign yields rose relative to German sovereign yields. There was reason to be anxious. I argued that “Some kind of political solution at the EU level would be needed” (link).

This we got. The European Union agreed on a “Recovery and Resilience Facility” (link) that includes both loans and grants. EU has moved one inch closer towards a common fiscal policy. Who will pay is not clear, but EU has shown solidarity. I believe this is positive. At the same time, the European Central Bank continued its interventions and bought a lot of Italian debt. This has kept yields on sovereign bonds low. Here is the Italian-German yield spread during 2020:

Italian yield spread towards Germany. Ten-year government bonds. Daily data: January 2, 2020 – December 21, 2020.
Data source: Thomson Reuter Datastream via Eikon.

Italian yields have been falling continuously since summer, when the EU agreed on its recovery plan. It is positive that we have not had to discuss Eurozone troubles. We have had so many other troubles. Whether this means that we do not have to discuss Eurozone troubles again at some point, I am less sure. But, that is for another day.

Banks have been doing OK

The risk of a Eurozone breakup did not materialize. Another risk that did not materialize was the risk of systemic bank failures. This is positive as well, as economic activity suffers so much more when banks run into trouble and credit consequently does not flow to its productive uses.

During the worst days in March, stress in the banking system intensified. For instance, the spread on unsecure interbank lending increased relative to secure lending:

The TED spread. Difference between 3-Month USD LIBOR and 3-Month US Treasury Bills. Daily data: January 2, 2000 – December 14, 2020. 2020 encircled.
Data source: Fed St. Louis Database.

Stresses lasted only a few days, though. During the financial crisis in 2008, on the other hand, spreads remained elevated for much longer. This time, trust in the banking system was quickly reestablished.

I think I am allowed to claim that this was one of the predictions I got reasonably right. In autumn 2019, when nobody knew about the upcoming crisis, I wrote a policy paper on the Nordic financial sector. It was presented in December 2019 and finally published in June this year (link). I argued that banks are safer today, compared to 2008. Some doubted my conclusion and said, “just wait until the next crisis, then you will see that banks are not safer today”. Well, few months later we had the worst recession ever. Luckily, though, we have not had bank-rescue packages and we have not had to bail out banks. Banks have been withering the storm. In some instances, banks have even been part of the solution by showing flexibility towards troubled firms. I am not saying everything is perfect, but I am saying that the situation has been very different from the situation in 2008. On a personal note, this made me happy, too, as it would have been somewhat embarrassing if banks had failed at the same time I published an analysis arguing that the banking sector is safer. This, luckily, did not happen. Instead, the banking system turned out to be far more resilient than in 2008, as I predicted.

You may add that the Fed rescued markets during spring, as mentioned above, and thereby rescued firms and subsequently banks. True, but there was certainly also tons of rescue packages in autumn 2008. Banks nevertheless failed in large numbers in 2008. They did not this time around. Perhaps, thus, we did learn something from the financial crisis of 2008, and have gotten some things right. This would be no small achievement.

US election and Brexit

There have been other events, for instance the US election and Brexit negotiations. In normal years, such events would potentially have been among the most important events for markets and the economy. This year, the pandemic has certainly been more important. I did manage to write a post on the US election and the stock market, though (link). I discussed evidence that stock markets perform better under Democratic presidents. Only time will tell whether the same will happen under Biden.  

I did not manage to find space to discuss Brexit, but we got a trade agreement on Dec. 24 (link). Hopefully, the EU and UK can now move on.

The cost of the crisis

It is impossible to summarize the pandemic in one number or one word. Hence, I will not attempt to do so. But, I did present a calculation of the expected cost of the crisis in Denmark (link). I arrived at DKK 336bn, or app. USD 10,000 per Dane. This calculation generated some attention in Denmark.

One can discuss every single assumption one needs to make when calculating the expected cost of a crisis: What is the value of a statistical life? What is the value of a statistical life of those who pass away due to COVID-19, i.e. who are typically above 80? What is the past loss as well as the expected future loss in economic activity due to the crisis? Does it make sense to present one number when there is so much uncertainty? And so on. These are all fair points, but if we want to have a meaningful discussion of the impact of the crisis, we have to start somewhere.

In my calculation, I closely followed the assumptions of Cutler & Summers, such that US numbers and Danish numbers can be compared. This allowed me, for instance, to conclude that the cost of the crisis in Denmark, most likely, will be much lower than the cost of the crisis in the US.

Conclusion

I must admit I find it difficult to end this last post of 2020 on a happy note. Right now, at the time of writing, the situation is bad in the country I live, Denmark, and in many other countries in Europe and around the world. Numbers of new cases and deaths have been rising recently, or are on the rise again, and more and more restrictions and lockdowns are being imposed. Days are grey and short. The crisis has already been tremendously costly and it is clearly not over yet.

Nevertheless, I will try to end the post on a positive note. It gives me hope that several countries have started vaccinating people, and it seems to be working well. Finally, the EU also starts vaccinating people now. This has taken way too long, however, given the severity of the crisis and the fact that other countries started weeks ago. And, yes, every day counts. If it is correct, though, and I deliberately write if, that the EU has failed when it comes to the approval process and purchase of vaccines, as the normally well-informed and serious magazine Der Spiegel claims (link), it is a scandal. Biden aims to vaccinate 100m Americans within his first 100 days in office (link), close to a third of the US population. As things look now, it seems unlikely that we will be able to achieve the same in Europe. Christmas is all around us, though, so let us hope that somehow things will develop in the right direction.

Therefore, let me focus on the bright side. With the jabs, the situation will most likely start to improve within a not too distant future. I will try to convince myself that I see weak light at the end of the long and dark tunnel, even when we probably have to wait many months before things really calm down. Days are at least getting longer. I will focus on this, then.

With this, which is meant to be a positive message, let me thank you all for reading this blog and for sending me many encouraging mails with feedback. Please keep on doing so – it is highly appreciated.

I conclude by expressing hope that next year will be considerably more joyful than the one we leave behind.

Happy New Year!

Italy vs. Greece

There are similarities between Greece in 2010 and Italy today that make me nervous.

Do you remember the Greek drama in 2010-2012? Following the financial crisis in 2008-2009, Greece saw it public finances deteriorate, as did most other countries. The special thing about Greece was that they had fudged the numbers. In autumn 2009, the new Greek Prime Minister, George A. Papandreou revealed that the former government had lied about the deficit. This, and the recession, brought public debt to 146% of GDP in 2010. It later turned out that Greece had also falsified the numbers – via different swap contracts, willingly helped by US banks – prior to the introduction of the euro, making the whole thing even worse. With debt running at close to 150% of GDP in 2010, investors lost faith. Greek yields skyrocketed (see below). Greece received a number of rescue packages from the EU commission, IMF, and the ECB (the so-called “Troika”). Eventually, in 2012, Greece restructured its debt in the largest sovereign default in history. Investors faced a loss to the tune of EUR 100bn.

Why do I repeat this sad story? Because the IMF Fiscal Monitor Report contained a forecast for Italy that has, in my opinion, not received enough attention. The IMF predicts that Italy will reach a public debt level of 150% of GDP this year, exactly like Greece in 2010. Will this lead to a replay of the European debt drama?

First, the data. We are in the middle of a terrible recession. Italy has been severely affected by the corona virus, and has as a consequence enforced a strict lockdown. IMF expects that Italy will be one of the worst hit countries. Italian GDP is expected to fall by 9.1% during 2020.

IMF also expects that the fiscal deficit will be 8.3% of GDP in 2020. This is a large deficit, but other countries face even larger ones. The US, for instance, 15.4% of GDP (this probably requires another blog post…..), China 11.2%, Spain 9.5%, and so on.

The problem in Italy is that public debt levels are already very high, at 130% of GDP. Few countries match this. In fact, only Japan and Greece. What is noteworthy, in my opinion, is that the combination of the already high debt level, the severe recession, and the fiscal deficit will most likely take the debt level to more than 150% in 2020:

Greek and Italian public debt as a percentage of GDP. Data for 2020 and 2021 are forecasts from the IMF.
Data source: EU Open Data Portal and IMF Fiscal Monitor Report.

The figure superimposes a dotted line indicating the 146% debt-to-GDP level Greece reached in 2010, which sparked the Greek problems. Italy is expected to cross this line in 2020.

Contributing to my concern is the fact that financial markets seem to treat Italy and Greece somewhat similar this time around, in contrast to 2010. This time, movements in the Italian yield spread to Germany largely mirror movements in the Greek yield spread:

Greek and Italian yield spread towards Germany. Ten-year government bonds. Daily data: January 2, 2020 – April 30, 2020.
Data source: Thomos Reuter Datastream via Eikon.

The spread between Greek and German ten-year government bonds is a little higher than the spread between Italian and German government bonds, but movements are very similar. Only between the ECB/Christine Lagarde blunder on March 12 and the introduction of the PEPP (see below) on March 18, there was some divergence between Italian and Greek yields. Otherwise, they have moved in tandem.

This is different from 2010. In 2010, Greek yields spiraled out of control, reaching close to 50% on the worst days, but something like 25% for the worst month on average:

Greek and Italian yield spread towards Germany. Ten-year government bonds. Monthly data: 2000-2020.
Data source: St. Louis Fed.

The Italian spread also increased in 2010, but, back then, markets clearly distinguished between Greece and Italy. Today, markets view Italy and Greece as being in somewhat similar situations. Rating agencies have started to act (Link).

Will we see a repetition of the Greek drama?

The Greek yield spread was close to 50% on the worst days in 2010, and currently we are talking something like 2.5% for Italy, i.e. very far from 50%, though up from 1.5% in the beginning of the year. This is clearly not as bad as in 2010. I thus hope that we will not see a repetition of the Greek story in Italy, but I dare not rule it out.

Let us start with the good news. Yields are lower today than in 2010. In 2010, Italian yields were around 4%. Today, they are around 2%. Hence, if yields stay low, Italy can afford a larger public debt compared to the situation in 2010. Also, everybody is aware that problems in Italy will mean problems for Europe, as I describe below, i.e. everybody wants to avoid such a situation.

On the other hand, the situation could turn to the worse if the recession in Italy will be deeper than the IMF expects, if the Italian political situation takes another turn to the extreme, if political negotiations at the EU level about a recovering plan do not bear fruit, or if some other negative shock occurs. Should some of this happen, Italy might find itself in something like the Greek situation at some point. The situation is fragile, as shown by the widening of spreads and the downgrade of Italy.

Italy is important for the European project. It is a G7 country. It is one of the founders of the EU. The foundation of the euro would be threatened if Italy runs into trouble. It would have global repercussions. At the same time, Italy is probably too big to bail out for the rest of the Eurozone/EU.

Some say that the ECB will make sure that this will not happen. Perhaps, but this is not as obvious as some claim. We get into technical nitty-gritties here, unfortunately, but it is important to understand.

ECB is buying bonds like crazy at the moment, keeping a lid on yields, including Italian. The ECB’s PEPP (Pandemic emergency purchase programme) implies that the ECB will buy public and private securities to the tune of EUR 750bn during 2020. I.e., the PEPP will help keeping Italian yields down.

Furthermore, at the ECB Governing Council meeting Thursday, April 30, it was decided that “The Governing Council will conduct net asset purchases under the PEPP until it judges that the coronavirus crisis phase is over, but in any case until the end of this year” and “The Governing Council is fully prepared to increase the size of the PEPP and adjust its composition, by as much as necessary and for as long as needed”. Hence, the PEPP might last longer than throughout 2020 and accumulate to more than EUR 750 bn.

BUT, the important sentence in the PEPP programme is this one: “For the purchases of public sector securities under the PEPP, the benchmark allocation across jurisdictions will be the capital key of the national central banks. At the same time, purchases will be conducted in a flexible manner. This allows for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions.” (Link).

This point here is that that ECB cannot – and I repeat cannot – buy unlimited amounts of Italian debt at the moment. The proportion of Italian bonds the ECB can buy (as a proportion of all Eurozone sovereign debt ECB buys) is restricted by the Italian fraction of ECB capital. At the moment, this is, to be very precise, 13.9165%.

It also says that this will be interpreted in a “flexible manner” – and I am sure the ECB will be flexible – but they cannot be too flexible. ECB just cannot buy unlimited amounts of Italian debt under current programmes.

There is an escape clause: OMT (sorry for this soup of abbreviations; ECB, PEPP, OMT,…). OMT is “Outright Monetary Transactions”. OMT allows ECB to buy unlimited amounts of Italian (and other Eurozone) bonds, should this be necessary. But, and this is a big but, only when the relevant country has entered into a program with the European Stability Mechanism (ESM; one more abbreviation…). An ESM program means that the country will face demands with respect to its conduct of fiscal policy; think about the discussions about the role of the Troika in the Greek drama. To some extent, this is a loss of sovereignty. Entering into a program is also a signal that the country cannot handle the situation on its own. This will make it even more difficult to sell bonds on the market. At the moment, Italy very clearly opposes an ESM program. At the end of the day, this however means that ECB cannot buy unlimited amounts of Italian debt should this become necessary. ECB cannot save Italy.

Other people say “look at Japan”. Japan has a public debt of more than 200% of GDP. IMF expects it to reach 252% of GDP in 2020. Yields in Japan are very low, in spite of this massive debt mountain. I.e., Japan shows that you can accumulate lots of public debt without causing yields to rise, some claim. True, but remember that Japan has its own currency and its own central bank. The Japanese central bank can buy all the public debt they want, keeping Japanese yields down. Italy does not have its own central bank and its own currency. The ECB cannot buy unlimited amounts of Italian bonds. Greece is the example that shows that the situation of a Eurozone country is different from the situation of a country with its own currency and central bank.

(Here, I do not want to get into a discussion whether a country with its own currency and central bank faces no limits on the amounts of public debt it can raise, as argued by proponents of the “Modern Monetary Theory”.  Basically, I disagree with that policy implication and think there is a limit, but this is for another day).

So, in the end, if worst comes to worst, ECB cannot save Italy, unless Italy enters into an ESM program. Some kind of political solution at the EU level would be needed. I hope we will not get there. At the moment, we are not, but I dare not rule that we might get there. I will follow the Italian situation.

Eurozone in trouble again, but this time with a new twist

Fear of a new Eurozone debt crisis, similar to the one in 2010-2012, resurfaced in March. Within a week or two, Italian yields more than doubled. Given Italy’s large stock of sovereign debt, nervousness increased. Since then, yields have come down and markets stabilized somewhat. A key difference to the European debt crisis of 2010-2012 is that yields on “safe” assets, like German and US yields, rose, too. What happened and will calm remain?

First, the facts. This figure shows Italian yields (yield on a ten-year sovereign bond), as well as its spread to the German ten-year government bond yield, from the beginning of the year through April 14. The spread to German bonds is larger than the Italian yield itself because German yields are negative (see below).

Yields on Italian ten-year government bond and spread to German.
Data source: Datastream via Thomas Reuters Eikon.

Bond markets were calm in the beginning of the year, only to explode from March 3 through March 18. On March 3, the Italian benchmark yield was one percent. On March 18, it was 2.4 percent. Similarly, the spread to German yields rose. Given the speed of the adjustment, and the size of Italian government debt, this is worrisome. It reminds us of the situation in 2010 where yields on debt from Italy and other southern European countries rose sharply. There are, however, additional ingredients to the story this time.

The worry with Italy is that it will face difficulties remaining solvent if its yields rise. And, given the size of the Italian debt mountain, it will be difficult for the Eurozone to bail out Italy. It is also a story of disastrous communication by the new ECB chief Christine Lagarde, who at the ECB Press conference on March 12 said the by-now famous words “We are not here to close spreads”, meaning ECB will not come to the rescue of Italy. Many of us wonder why Italy has not tried to stabilize its finances since the European debt crisis, but this was not the right time to raise this point. Italy was in the middle of the terrible corona crisis and markets were nervous. The remark of Lagarde should have been saved for another day. Markets tail-spun.

This time around, however, there is an additional element to the story. Something unusual happened in other bond markets. Look at this graph.

Yields on ten-year government bonds from different countries.
Data source: Datastream via Thomas Reuters Eikon.

It shows yields on ten-year sovereign bonds from a number of countries. Italian rates spiked, as mentioned. However, and this is the curios fact, rates of what is typically viewed as safe-haven bonds also rose dramatically.

German yields rose from their low of minus 84 basis points on March 9 to minus 17 basis points on March 19, an increase of more than sixty basis points. The same goes for Danish and Dutch yields. Denmark, the Netherlands, and Germany are Triple-A rated. Even US yields more than doubled, from fifty basis points to 126. A rise of eighty basis points in US yields within a week or so is very dramatic. It is also very different from what we typically see during times of crises. Typically, in crises, investors sell risky assets and buy bonds of safe-haven countries, causing their yields to fall. This did not happen in March. If safe assets lose value during crises, where should investors seek shelter?

So, this is a story about Italy and a reassessment of the credit risk of Italy. But it is more than this because otherwise safe havens saw yield rose, too, exerting an additional upward pressure on Italian yields.

From early March to mid-March, Italian yields rose by almost 150 basis point. The yield spread to Germany “only” rose by 100 basis points. The difference is the rise in German yields.

This BIS Bulleting provides an interesting account of what caused the rise in US yields during early-mid March. They only look at the US, but probably some of the same factors caused the effects in Germany. BIS argues that hedge funds and other levered investors were forced to sell because of margin calls. “Leverage” means that you borrow to invest and “margin calls” means that you have to come up with extra money when the assets you have bought for borrowed money fall in value. So, when you have borrowed a lot to invest (you are highly leveraged), you will face large margin calls. In this case, you have to sell many assets to generate a lot of cash you can pledge as security. If markets function “perfectly”, dealers will be able to absorb the sales and build up inventories. Prices should be unaffected. But if dealers cannot absorb the sales, for instance because dealers are subject to capital requirements and cannot raise capital immediately, then there is nobody out there to buy and prices of bonds fall and yields rise. BIS argues that these events had spillover effects on other types of investors causing them to sell bonds, too. I.e. a lot of investors had to sell, causing such a big effect. In their FSR, IMF is aligned.

More broadly, BIS argues, these events imply that central banks might need to employ different tools from what they have been used to during previous crises (buy bonds from dealers instead of providing liquidity). The events also imply that a different composition of sovereign bond investors (leveraged private investors instead of sovereign wealth funds) could imply different market dynamics during periods of stress.

Where does this all take us? First, I am still worried about Italy. The Italian sovereign debt is huge, and the situation is shaky. Right now, it might look OK. Italian yields are higher than in January and February, i.e. spreads to e.g. Germany have widened, but not by too much, even if the tendencies of the last couple of days might be worrying. Unrest could easily resurface, however. In addition, events in March told us an important lesson about the implications of changes in market structures. If owners of sovereign bonds of safe countries are mainly leveraged private investors, and if dealers cannot absorb large sell-offs, even yields of safe-haven assets might rise during turmoil. This is worrying for investors, as they will then have fewer places to seek shelter during times of stress.

So, Italian yields rose because investors repriced credit risk in Italy and ECB made a blunder. Spreads to Germany rose. But, Italian yields also rose because yields on safe assets (German and US) rose, pushing up all yields. The latter effect is new, and somewhat scary.